Question
In: Finance
1. The Frosty Delights Ice-cream House currently rents an ice-cream machine for $50,000 per year, including...
1. The Frosty Delights Ice-cream House currently rents an
ice-cream machine for $50,000 per year, including all maintenance
expenses. It is considering purchasing a machine instead, and is
comparing two options:
I. Purchase the machine it is currently renting for $150,000.
This machine will require $20,000 per year in ongoing maintenance
expense.
II. Purchase a more advanced machine for $250,000. This
machine will require $15,000 per year in ongoing maintenance
expense and lower annual packaging costs by $10,000. Additionally,
the machine will require an upfront expense of $35,000 for training
of operators.
Maintenance and packaging costs are paid at the end of each
year, but the rent of the machine is paid at the beginning of the
year. Suppose the appropriate discount rate is 7.75% per year.
Assume also that the machines will be depreciated via the
straight-line to zero method over seven years and that they will be
used for 10 years with no salvage value at the end of use. The
marginal corporate tax rate is 22%. Should the Frosty Delights
Ice-cream House continue to rent, purchase its current machine, or
purchase the advanced machine? (10 points)
Solutions
Expert Solution
Buying the current machine is the best option with highest NPV
| NPV | $54,069.46 |
NPV of buying new machine =
| NPV | $49,974.16 |
Workings
| Buy Current machine | |||||
| Year |
Saving in rent post tax |
Purchase price |
Maintenance after tax |
Tax shield | Net CF |
| 0 | 39000 | -150000 | -111000 | ||
| 1 | 39000 | -15600 | 4714.29 | 28114.29 | |
| 2 | 39000 | -15600 | 4714.29 | 28114.29 | |
| 3 | 39000 | -15600 | 4714.29 | 28114.29 | |
| 4 | 39000 | -15600 | 4714.29 | 28114.29 | |
| 5 | 39000 | -15600 | 4714.29 | 28114.29 | |
| 6 | 39000 | -15600 | 4714.29 | 28114.29 | |
| 7 | 39000 | -15600 | 4714.29 | 28114.29 | |
| 8 | 39000 | -15600 | 23400.00 | ||
| 9 | 39000 | -15600 | 23400.00 | ||
| 10 | -15600 | -15600.00 | |||
| NPV | $54,069.46 | ||||
| New Machine | ||||||
| Year |
Saving in rent post tax |
Purchase price |
Maintenance-packing after tax |
Tax shield | Training cost | Net CF |
| 0 | 39000 | -250000 | -27300.00 | -211000.00 | ||
| 1 | 39000 | -3900 | 7857.14 | 42957.14 | ||
| 2 | 39000 | -3900 | 7857.14 | 42957.14 | ||
| 3 | 39000 | -3900 | 7857.14 | 42957.14 | ||
| 4 | 39000 | -3900 | 7857.14 | 42957.14 | ||
| 5 | 39000 | -3900 | 7857.14 | 42957.14 | ||
| 6 | 39000 | -3900 | 7857.14 | 42957.14 | ||
| 7 | 39000 | -3900 | 7857.14 | 42957.14 | ||
| 8 | 39000 | -3900 | 35100.00 | |||
| 9 | 39000 | -3900 | 35100.00 | |||
| 10 | -3900 | -3900.00 | ||||
| NPV | $49,974.16 | |||||
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$150,000. This machine will require $20,000 per year in ongoing
maintenance expense. Purchase a new more advanced machine for
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